March, 2011

BEWARE THE BIG BAD BOND BUBBLEby LARRY

Despite a great deal of market volatility, investors whose portfolios were well diversified have probably done reasonably well over the last three years or so. And although the performance of the S&P 500 Index has been essentially flat in the past 10 years, rising only a bit less than 1% annually, total returns have roughly doubled one's money for those who were well allocated and annually rebalanced.

This contrasts markedly, however, with the performance record of the average investor who may have been too heavily in stocks, felt panic and sold well into the steep bear market of the fall 2008 through early 2009 period, and then waited until the new bull market was well underway before buying into it, that is, once prices were already heading back up.

All too typically, retail (as opposed to institutional) investors in general acted on emotion more than reason, sold low, and then bought high, the opposite of the most basic lesson for investment success.

Many, in fact, are now still in what they see as the reliable, secure, safe haven of bonds even while stocks have regained 100% or more of their end of 2007 value. This may seem like the right place to have been during a devastating time for equities. Bond mutual funds, for example, have in many cases beaten stock mutual funds since 12/31/07. Yet the risks of being substantially in bonds and out of stocks are increasing.

Individual bonds are OK as long as one can hold them to maturity. But the market price of bonds and bond mutual funds, like stocks, can vary up and down at intervals short of their end values. And bond mutual funds for the most part have no such secure maturity value. Some bonds may also be callable, which means they can be bought back at the seller's discretion and at the price then, which may not be advantageous to the buyer.

A variety of circumstances can cause bond prices to fall. A major one is an increase in interest rates which, in turn, result in higher yields on new bonds, making the old ones (with lower yields) less attractive. A 1% rise in interest rates, for instance, can cause a drop of over 12% in some types of bonds.

Even some of the recently best performing bond mutual funds have dropped considerably. The convertible bond category of funds, though having a 5-year average return of 6.5%, at one time in that period fell over 34%. Particular bond mutual funds have done badly on occasion as well. Fidelity Capital and Income Fund (FAGIX), though providing a 5-year average return of 10% a year, fell 33.2% during the last bear market. At that time, the losses were not due to rising interest rates but to a perceived risk of financial system failure.

Unusual inflation may also make bonds less attractive and so lead to lower prices. Bonds and bond mutual funds in general are presently priced relatively high due to: the unprecedented lowering of the Federal Reserve's discount rate to near zero; greater concern with deflation than inflation; a flight-to-safety rush of investors (increased demand) into bonds (of limited supply) after investors had been burned in stocks; and the government itself buying up more shares of Treasury Bonds. Bonds on the whole are thus high now because of a set of circumstances more favorable than in most of my lifetime, one unlikely to be soon repeated or long sustained.

In the future, some or all of these very bullish bond market conditions are likely to change. I am concerned that some folks may have become complacent and might not be ready for when this bond bubble turns into a snarling bond bear.

To give just one illustration of how this might occur, higher energy and food costs of late, if they persist, will affect the costs of goods and services overall, which, in turn, will cause businesses to raise their prices. Foreign investors, concerned about the lowered relative value of the U.S. dollar in a more inflationary environment, will demand higher bond interest rates for them to stay interested in purchasing our bonds. To better address inflation as well as foreign investor worries and to avoid losing our country's top credit rating, the Federal Reserve will find it necessary to raise rates. The higher rates will be passed along to mortgage-backed bond securities, corporate bonds, etc. (The need for higher rates could also come about due to, for example, Japanese investors in U.S. bonds having to sell their shares [decreased demand and increased supply] in order to fund new Japanese construction, following the devastation from the 3/11 earthquake and tsunami, subsequent aftershocks, severe damage to nuclear reactors, etc. To attract more buyers, then, rates would have to increase.)

As mentioned earlier, once the rates begin to go up, the prices of bonds will go down. Their cost must be reduced enough to raise their yields until they are competitive with new bonds being issued at the higher rates.

The longer the bond duration, the greater the risk of loss. A 30-year corporate bond, for instance, will fall much more severely than a 2-3 year one.

This is all a perhaps long-winded way of saying that if an investor is - as many are - too heavily invested in bonds or bond funds, particularly long-term ones, and/or will not likely be able or willing to hold his or her bonds to maturity (when they will be worth their face value), now or in the next few months may be an appropriate time to rebalance one's portfolio, restoring a long-term intended stocks/bonds allocation and/or shortening the bonds' maturity or duration.

Am I certain that bonds will soon be heading south or that they are now more risky than stocks? No. However, the price to risk (higher risk now for bonds) and price to value (lower value now for bonds) ratios seem in general more to favor equities over bonds today. Stocks also, after a considerable run-up in price since early March, 2009, are now carrying higher risks of loss, but not so much so.

As a result, I suggest a four-pronged approach:

1. Raise the level of your cash-equivalent assets. If used to a 10/30/60% allocation, for instance, of cash reserves, bond assets, and equities, now may be a good time to raise the cash type portion to 20% or higher;

2. Lower the average maturity or duration of your bond or bond mutual fund holdings. If you tend to hold long-term bonds or bond funds, a switch to intermediate - or short-term ones may now be prudent.

3. Decrease the percent of your assets that you hold in bond type assets. Particularly if you significantly increased bond holdings after 2007, reestablish a more diversified allocation. If you have tended to have 10% cash, 30% bond assets, and 60% stock or stock mutual funds, for instance, but right now it is closer to 5% cash, 70% bonds and 25% stocks, bear in mind that bonds often react worse than stocks to a variety of circumstances - like inflation - and gradually (perhaps over the next few months) restore something closer to your customary diversification, except with a bit more caution even than usual, perhaps now going for - just as one example, but you must decide what is right for you - 25% cash, 25% bonds, and 50% in equities.

4. If you have, after the 2008 - early 2009 equities debacle, severely reduced your exposure to stocks or stock mutual funds, but have not then raised it again, now would be a good time to gradually increase equity holdings, especially in carefully selected value positions.

The bottom line point here is that a well allocated portfolio, rebalanced annually, can usually do fairly well on a risk adjusted basis up to and including the most volatile of market conditions for either bonds or stocks. However, too much focus on one or the other, even following near economic meltdown circumstances, may be hazardous to your financial health. Re-diversify now if an objective analysis of your portfolio shows it is skewed too much in favor of one or the other. Moreover, since, following the bull market which began in March, 2009, both stocks and bonds have now been unusually profitable of late, caution would suggest that one raise some additional cash reserves, with which to later take advantage of bargain prices that may develop in debt instruments, equities, or both.

DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)